Debt Cycle Investing – My Asset Allocation Idea. And My Book Title.

Aug. 5, 2018 11:04 AM ET

Summary

Debt growth cycles are critical to economic and stock market cycles.

I make this point using easy-to-read charts.

This blog is designed as an extension of a book I just published called “Debt Cycle Investing”. If you are one of the few humans once and now living who haven’t heard of it, see my profiles on ESPN2 and The Cooking Channel. Or the “Book” tab on my web site. The purpose of the book is to give you a profitable new twist on the allocation of your financial assets – stocks, bonds and cash. I keep it real simple; stocks are represented by the S&P 500 index, bonds by the 10-year Treasury bond and cash by a 1-year bank CD.

I have no argument with traditional asset allocation rules of thumb. The standard rule of thumb for the average investor is “60/40”; that is, 60% of assets in stocks and 40% in bonds. I adjust it to 55%/35%/10% to make room for 10% in cash. This rule is then quite logically adjusted for age by using the “rule of 100”, which suggests that your stock allocation should be 100 less your age (for example, a 20-year old should have 80% of assets in stocks). That makes good common sense, because the younger you are, the more you can withstand the risks of holding more volatile stocks, and vice versa.

So far, so good. But take a look at this chart:

Sources: Federal Reserve, Yahoo Finance, Standard & Poor’s

Wouldn’t it have been awesome to have over-weighted bonds and under-weighted stocks in 2000 and 2006? “Sure it would have”, you should be saying, “but are there reliable signals to have helped me make those calls?”

Stock markets returns historically correlated very well with private sector (consumer and business) debt growth. Huh? Debt growth is not something you hear about much. But the fact is that rising private sector debt growth drives rising stock prices, as vice versa. How? Through several interim steps:

Stock prices are largely driven by earnings growth expectations, as I discussed in several recent posts.

Earnings growth is in turn in large part a function of US and global economic growth.

Cyclical economic growth is heavily driven by debt growth.

Changes in economic growth are driven by debt growth? Why not job growth? Or interest rate changes? Or tax cuts or increases? The book goes into the details of why not, but let this chart suffice to prove that debt growth is very important to economic cycles:

Sources: Bureau of Economic Analysis, Federal Reserve

A correlation this close is pretty rare in economics. The investment conclusion is therefore pretty clear to me: If you can forecast changes in the growth rate of private sector debt, you can forecast stock market trends and therefore improve your asset allocation decisions. And the good news is that it is not that hard to forecast private sector debt growth. Again, the book explains how to do that. The book seems like a bargain at $16.95 on Amazon, doesn’t it? I’m just saying.

It’s simple, but not quite that simple.

A life lesson is that if something feels good, we tend to overdo it. And to figure out how to keep doing it after we’ve overdone it. Debt is like that. Spending borrowed money feels good. “I get to buy stuff with money I haven’t earned yet? Cool.” Inevitably we humans tend to overborrow, and to want to keep borrowing even after we’ve overborrowed. If you think I’m just being cynical, check out this chart, which compares the amount of total debt (consumer + business + government) we US citizens hold as a percent of the income we earn (represented by GDP):

Sources: Bureau of Economic Analysis, Federal Reserve

As a result, two entities have stepped up to help us to keep overborrowing – the federal government and the Federal Reserve. Their policies have grown in importance in sustaining debt growth. (What books explains these trends? Hmm…) Therefore, investors allocating their assets today have to take into account trends in government borrowing and Federal Reserve interest rates policies more than they have in the past.

OK, now you have a little idea of how watching debt growth trends can improve your investment asset allocation results. So let’s call it a day. Next week I will show you how I practically link my debt growth and other investment variables to actual asset allocation decisions, and I’ll introduce a dashboard to keep track of those variables. Have fun until then.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.